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The Tax Court has determined that a distribution from an individual retirement account (IRA) that satisfied the early distribution penalty exception for qualified higher education expenses was not a modification of a series of substantially equal periodic expenses (another exception to the early distribution penalty). Therefore, the court concluded that the rule prohibiting modification (other than by death or disability) of the substantially equal periodic payments before the later of age 59½ or the close of the five-year period starting with the first payment was not violated. It remains to be seen whether other courts or the IRS will adopt this position. In any event, great planning flexibility exists for avoiding the early distribution penalty using multiple IRAs.

Kim Benz maintained an IRA. In 2002, Kim started receiving a series of annual substantially equal periodic payments from the IRA. In addition to the substantially equal periodic payment for 2004, Kim received two distributions during 2004 that were used to pay her son's qualified higher education expenses. Kim had not attained age 59½ at the time.

Kim reported the distributions to the IRS. She claimed that the distributions were not subject to the early distribution penalty. The IRS determined that the two additional payments were a modification of the series of substantially equal periodic payments. The IRS determined that the amount of total distributions from the IRA in 2004 in excess of any qualified higher expenses for the year were subject to the 10 percent early distribution penalty.

In general, a 10 percent early distribution penalty applies to distributions from qualified plans and IRAs before age 59½, unless an exception applies. Exceptions for IRAs include, among others, distributions after death, on account of disability, that are a part of a series of substantially equal periodic payments, or for qualified higher education expenses. A series of substantially equal periodic payments must be made for the life (or life expectancy) of the IRA owner or the joint lives (or joint life expectancies) of the IRA owner and a designated beneficiary. If the series of substantially equal periodic payments are subsequently modified (other than by reason of death or disability) before the later of age 59½ or the close of the five-year period starting with the first payment, the early distribution penalty tax that would have applied except for the exception plus interest for the deferral period is added to income tax in the year of the modification. IRC Sec. 72(t).

The court concluded that the two exceptions to the early distribution penalty tax -- distributions that are part of a series of substantially equal periodic payments and distributions for qualified higher education expenses -- are two mutually available exceptions. Therefore, distributions for qualified higher education expenses, which were in addition to a distribution that was part of a series of substantially equal periodic payments, would not be treated as a modification of the substantially equal periodic payments. As a result, recapture of the early distributions penalty tax plus interest was not required.

If the court is correct, then distributions that meet another exception to the early distribution penalty tax, such as distributions for qualified higher education expenses, can be made in addition to distributions that are part of a series of substantially equal periodic payments without violating the modification to the substantially equal periodic payments rule. But, once substantially equal payments have begun, if distributions are made before the later of age 59½ or five years and total distributions for the year are less than the amount required under the substantially equal periodic payments method chosen, then there has been a modification unless the distribution exhausts the IRA. Under this rationale, certain other exceptions to the early distributions penalty tax might also be made in addition to distributions that are part of a series of substantially equal periodic payments without violating the modification to the substantially equal periodic payments rule. These exceptions include distributions for medical care to the extent that such expenses exceed 7.5 percent of adjusted gross income and for purchase of a first home ($10,000 lifetime limit).

It remains to be seen whether other courts or the IRS will adopt this position. Many have long concluded that any modification of substantially equal periodic payments before the later of age 59½ or five years is subject to the penalty tax except in the case of death or disability. IRC Section 72(t)(4) specifically mentions death and disability as exceptions to the modification of substantially equal periodic payments before the later of age 59½ or five years rules, and mentions no other exceptions.

It may be that the decision, in part, reflects the IRS' presentation in this case, which was fully stipulated. The statute provides for recapture of the early distribution tax for all years plus interest. The IRS determined only a penalty tax for a portion of the payments in 2004, and not for payments in 2002 and 2003 plus interest. In addition, it appears that the court focused on modifications within five years, even though the focus of the early distributions statute, especially the substantially equal periodic payment portion, is on age 59½ and the possible violation in this instance was modification before age 59½.

In any event, great planning flexibility exists for avoiding the early distribution penalty using multiple IRAs. The IRA owner can specify which IRA or IRAs the calculation of substantially equal periodic payments is to be based on. Account balances can be adjusted by splitting IRAs or through rollovers. After substantially equal periodic payments have begun from one IRA, a distribution from another IRA that qualifies for an exception to the early distributions penalty tax (e.g., substantially equal periodic payments or qualified higher education expenses), can be made without disqualifying the earlier substantially equal periodic payments. This type of planning is available regardless of whether Benz is ultimately followed by other courts and the IRS.

Benz v. Comm., 132 TC No. 15 (2009)

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About the Author

William J. Wagner, J.D., LL.M, CLU, is the author of the Ultimate Trust Resource (including the Trust Calculator), and the Tax Facts Ultimate IRA Resource (including the IRA Calculator). He is also a Senior Associate Editor of Tax Facts on Insurance & Employee Benefits, Tax... More